Back in the early to mid 1990s, Olive Garden was a fast-growing restaurant concept. It was priced at the low end of casual dining concepts, perhaps above the bar and grille sub-segment, which is the traditional leader of the low end of casual dining.

Looking at the Italian chains back then, there was a pretty well-developed, I felt, pecking order: Macaroni Grill was a step up in terms of food and check, and the then newer Carrabba’s chain was another step up to the top of the segment.

Along the way, Macaroni Grill had some business missteps that let Olive Garden, whose parent is Darden Restaurants Inc., become the undisputed number one national Italian chain with all of the economies of scale attendant to national advertising, name recognition, and share of advertising voice that follows. One of the things that Olive Garden’s marketing people have done masterfully since the 2000 recession, in my opinion, is advertise and establish a value image in the minds of its customers while continually raising relative prices. That was my and my wife’s impression every time we went, which was increasingly infrequent.

In the first half of this fiscal year, even as food ingredient cost-of-goods-sold increases were easing, there was investor concern for earnings growth at Darden Restaurants Inc. The concerns mostly revolved around Olive Garden, the largest and easily most profitable chain in the company. Some of this controversy involved efforts to change advertising and “invest” in more affordable meals such as $12.95 three-course dinners to help traffic and not overly hurt margins. At the same time, I looked at the same store sales growth for Olive Garden, which had been weak for some time, while Carrabba’s, which is privately owned, had been showing same store sales growth for about 12 consecutive quarters -- interesting dichotomy there.

Comparing the menus, I found that the average entrée price was the same, about $17.50. Now it may well be that Olive Garden sells more lower priced menu items than Carrabba’s, but still, equal menu pricing seems to be very out of line. That night I was at Cheesecake Factory (NASDAQ:CAKE), which for 25 years has been, and still is, considered to be the gold standard of casual dining chains. It has prices at the high end of the segment. Looking at the menu, my conclusion was that Olive Garden’s pricing was equal to Cheesecake’s, which may well have tempered its increases in recent years because of the tough economy. This would be extremely discomforting to me if I owned Darden stock, especially in a pressured consumer environment where I saw private label (surrogate for pricing pressure) finally get to General Mills (NYSE:GIS), the last man standing in consumer staples, or any number of other examples I could recite.

The news in February of third fiscal quarter Olive Garden comps coming in +2% did not make a case for a turn up or down in the chain's future sales. And the weather was unusually warm. Then there was Darden’s annual analyst meeting, in which management tried, with some success, to build confidence in the company’s long-term growth rate, while still doing some hemming and hawing by eliminating an Olive Garden margin trend slide that had been included in former presentations. Management did say that most of its Olive Garden operating margin leverage is expected to come from a fixed advertising budget. Maybe. But for me all of its promotions, including $12.95 meals, smacks of the sort of hi-lo pricing that many supermarkets have employed without any success against Wal-Mart (NYSE:WMT), Target (NYSE:TGT), Costco (NASDAQ:COST), and others. At some point, a customer wants to go out to eat and just look at the menu without any qualms. So I see Olive Garden’s margins coming down longer term from a pricing level that is too high, or sustaining a loss of market share.

Beyond Olive Garden, Red Lobster (another Darden property) has had questions about how much the last two quarters’ promotions have helped a comp store sales trend that was last positive at 1% in FY2009. And Longhorn’s longer term operating margin growth will at least be somewhat challenged by a probable permanently higher price of beef in the face of $7 per bushel corn and its effect on gross margin percentage.

A few days ago, an Olive Garden coupon went out. There is history of this happening only when there has been traffic pressure. Again, was the weather too warm this past quarter?

Since I wrote the above missive, not enough has changed to make Darden stock attractive. One sell-sider looked at new numbers in this pricing problem and stated that the average check at Olive Garden is up 34% since 2000 versus a 23% increase for its peers. Taking that pricing differential out of EPS and adding back some volume gain to arrive at some base level of earnings for stock valuation would be very time consuming and likely not worthwhile because Darden may need lots of time to stabilize earnings -- as well as a lot of advertising and promotional pricing to gain back market share that is still being lost. The theoretical EPS number (including lower prices plus higher volumes plus additional advertising/promotional spending) might well be a large hit to normalized earnings.

Beyond that, management is still in denial about its pricing, and it is trying to utilize what it believes are more effective promotions. Market share is still likely to hemorrhage going forward.

At $47 per share, the stock, using EPS estimates (I have little faith in the guidance of $3.42) and adding back $.10 of closing costs on the Yard House acquisition, comes to $3.80 respectively for FYs 2013 and 2014. Given those EPS projections from my model, the stock discounts a 6% five-year implied EPS growth rate. Yet second quarter comp restaurant sales were negative 2.7%, which is 1%-2% points below the industry average. Cost cutting has probably run its course. Since Darden is not seeing a sales turnaround and taking into account the fact that the company that is now cash strapped by its restaurant expansion, I cannot expect that there will be significant share buybacks to help get to that 6% EPS growth, either.

My best guess now is that the stock might get attractive around $41.

No positions in stocks mentioned.

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